S Corp Distributions in Excess of Basis: When Your Own Money Becomes Taxable Gain

Most S corporation owners believe distributions are tax free. That belief is only half right, and the other half is where the trouble lives.

A distribution from an S corporation is tax free only to the extent of your stock basis. Once you take out more than your basis, the excess is taxed as gain. It does not matter that the money came out of a business you own, or that the corporation had cash in the bank. If your basis was not there, the gain is.

This guide explains how the rule works, why owners get caught, how the IRS finds the problem, and what you can do about it.

The Rule: IRC 1368

IRC 1368 controls how S corporation distributions are taxed. For an S corporation with no accumulated earnings and profits, IRC 1368(b) sets out a two-step rule:

• The distribution is not included in gross income to the extent it does not exceed the adjusted basis of your stock.
• If the distribution exceeds the adjusted basis of your stock, the excess is treated as gain from the sale or exchange of property.

The Form 7203 instructions tell you to report that excess as capital gain on Form 8949 and Schedule D. The instructions also say you do not increase your stock basis for that gain. Basis stays at zero.

If the Corporation Used To Be a C Corporation

Corporations with accumulated earnings and profits, usually from years as a C corporation, follow IRC 1368(c). Distributions come first from the accumulated adjustments account (AAA) and are treated under the basis rule above. The next layer is a taxable dividend to the extent of accumulated earnings and profits. Anything left after that goes back to the basis rule. If you converted from a C corporation, the analysis gets more involved, and you should not assume a distribution is tax free just because the K-1 shows a profit.

Stock Basis Only: The Trap With Shareholder Loans

This is one of the most common mistakes. An owner has lent money to the corporation, so the owner figures there is plenty of basis to cover distributions. There is not.

The distribution rule in IRC 1368(b) refers to the adjusted basis of your stock. Debt basis can absorb losses under IRC 1366(d)(1), but it does not absorb distributions. A shareholder with zero stock basis and a large loan to the company still recognizes gain on a distribution. If you want that money out tax free against your loan, the corporation has to repay the loan, and that has its own rules (covered below).

Ordering Matters: Distributions Come Before Losses

Basis is adjusted once a year, at the close of the corporation's tax year, under Treas. Reg. 1.1367-1(d). The order of those adjustments decides whether a distribution is tax free.

For tax years beginning on or after August 18, 1998, Treas. Reg. 1.1367-1(f) sets the order:

1. Increase basis for income items, including tax-exempt income, and excess depletion.
2. Decrease basis for distributions.
3. Decrease basis for noncapital, nondeductible expenses and certain oil and gas depletion.
4. Decrease basis for losses and deductions.

Because distributions come before losses, a loss year does not by itself turn a distribution into gain. The income for the year is added first, then the distribution comes off. IRC 1368(d) also confirms that the basis used to test a distribution reflects the income adjustments for that year. Losses that do not fit within your remaining stock and debt basis are suspended and carried forward under IRC 1366(d)(2).

The problem arises when distributions exceed beginning basis plus the current year's income. That usually happens after several years of losses, or after years of distributions nobody tracked.

Loan Repayments Can Create Gain Too

If your debt basis was reduced by prior losses and has not been restored, a repayment of that loan can trigger gain. Under Treas. Reg. 1.1367-2(d)(1), a repayment of debt whose basis was reduced and not fully restored is a recognition event. Restoration comes only from a net increase in a later year, under Treas. Reg. 1.1367-2(c).

The character of the gain depends on the type of debt. The Form 7203 instructions say gain on repayment of a formal note is capital gain reported on Form 8949 and Schedule D, while gain on repayment of open account debt is ordinary income reported on Form 4797. Under Treas. Reg. 1.1367-2(a)(2), open account debt is shareholder advances not evidenced by separate written instruments, so long as the outstanding balance does not exceed $25,000 at the close of the corporation's tax year. Above that, the balance is treated like a formal note for later years.

For more on how the IRS views these advances, see our guide to S corp shareholder loans and the IRS.

How the IRS Finds Excess Distributions

The IRS does not have to guess anymore. Form 7203 must be filed by a shareholder who receives a non-dividend distribution from an S corporation, among other situations. That form reports your beginning stock basis, the year's adjustments, and the distribution. If the form shows distributions exceeding basis and no matching gain on Schedule D, that is a visible problem.

The K-1 is the other half of the picture. Distributions show up on Schedule K-1 (Form 1120-S), box 16, code D. When an examiner sees years of distributions and years of losses, the first question is how you had basis to cover both.

In an examination, you need to be able to prove your basis. The Form 7203 instructions say it directly: you are responsible for keeping the information needed to figure the basis of your stock. If you cannot reconstruct your basis from formation forward, the examiner may simply treat it as lower than you claimed.

Our Form 7203 guide walks through the form line by line in concept.

Related Problems the IRS May Raise

Reasonable compensation. If you are a working owner taking large distributions and a small salary, an examiner reviewing your basis may also ask whether some of those distributions were really wages. That is a separate employment tax issue. See S corp reasonable compensation and the IRS.

Disproportionate distributions. Owners sometimes worry that uneven distributions among shareholders blow up the S election as a second class of stock. Under section 3.02 of Rev. Proc. 2022-19, the IRS will not treat disproportionate distributions as violating the one class of stock requirement if the corporation's governing provisions give all shares identical distribution and liquidation rights. The section says taxpayers do not need to seek relief from the IRS in that situation. If the governing documents themselves create different rights, that is a different and more serious problem, covered in our guide to second class of stock and ineligible shareholders.

Fixing the Problem

1. Reconstruct basis from the beginning. Start with your original contribution and walk forward year by year: income, distributions, nondeductible expenses, losses. Use the K-1s and the corporation's books. Do not start with last year's number unless you know it is right.
2. Separate stock basis from debt basis. Track each formal loan separately. Confirm the loans are bona fide debt that runs directly from you to the corporation. Under Treas. Reg. 1.1366-2(a)(2)(ii), a guarantee of a bank loan does not create basis until you actually make payments on it.
3. Quantify the gain for each open year. If distributions exceeded stock basis, figure the gain year by year.
4. Correct the returns. Report the gain on amended individual returns for open years, with accurate Forms 7203 attached. If you are already in an examination, the corrected computation becomes your position with the examiner.
5. Change how the company distributes cash. Going forward, check basis before you take money out, not after.

Your basis is a running total that only you are required to keep. If nobody has been keeping it, the IRS will be happy to keep it for you, and you will not like its math.